You may be asking yourself, “What is a relative valuation?” Well, it is not a method of evaluating family members (pun intended). A Relative Valuation is a method to value a company based on multiples such as Price-to-Earnings (P/E), Price-to-Book (P/B), Price-to-Sales (P/S), Price-to-Cash Flow, Dividend Yield, and Enterprise Value-to-Earnings Before Interest, Taxes, Depreciation & Amortization (EV/EBITDA). There are two basic categories of Relative Valuations, which are: 1) compared to other companies, industry, or sector (Comparables) and 2) compared to the company itself called Justified Ratios that is based on the company’s internal growth rate, Dividend Payout Ratio, Required Rate of Return, Net Profit Margin, and Cash Flow. One of the best way to learn is through examples. Therefore, I will start off by defining some terms/formulas and then provide an example of a Comparable Analysis along with a Justified Ratios Analysis.

I included Operating Margin, Net Profit Margin, Inventory Turnover, and Asset Turnover in the following analysis because these ratios provide insights into the kind of companies Warren Buffett (Trades, Portfolio) likes.

Warren thinks that the best kind of business to own is one with high profit margins and high turnover.

Warren believes the second-best kind of business to own is one with either high profit margins or a high turnover to compensate for lower profit margins.

Warren is not interested in owning a business with both low profit margins and low turnover.

We take the average ratios and use them to estimate the approximate value for Campbell’s soup. The Value column below contains the values for Earnings, Book Value, Sales, Free Cash Flow, Dividend, etc. When we multiply the value by the average ratios (Average Factor column), we obtain a relative value based on that metric. For example, when we multiply Campbell’s Earnings (Value) times the average P/E of the comparable companies (Average Factor) we obtain the Relative Value. As a result, you have a number of relative value estimates based on the average comparable ratios. You can then weight the values (i.e. If you prefer P/S then weight that more heavily).

Based on the Justified Ratio Formula as defined in the Terms section of this article, you can calculate the Justified Ratios and its implied Relative Value (i.e. current Earnings TTM (Value) * Justified Ratio = Relative Value for that metric). You can then value the company based on your own weighting for preferred ratios (i.e. base 20% of your Justified Ratios Analysis Valuation on 10% of P/S Relative Value). For the following, I assumed a required rate of return of 16% just for illustration purposes.

The final concept I want to discuss is normalizing the data for better results. To do this, gather the several years’ worth of data like in the following Campbell’s Soup Normalized Table below. Use your personal judgment to identify trends.

Take your normalized results to calculate normalized justified ratios. In addition, you may want to normalize the values if for example sales should be adjusted up or down based on your analysis. As result, you can obtain a normalized justified relative valuation for Campbell’s Soup.

PLEASE NOTE: This Relative Valuation sample is for illustrative purposes only. I did not spend time analyzing the appropriate discount rate, which could dramatically alter estimated values. However, you can use this method of Relative Valuation to be approximately correct rather than as Buffett says absolutely wrong. In addition, please apply the Margin of Safety principle when purchasing a security as taught by Benjamin Graham.

About the author:

Nelson Nguyen

Experienced professional with expertise in financial statement analysis, value investing, and financial modeling. Past employment with the government (Internal Revenue Service), banking, insurance, and accounting service sectors. Licensed CPA with individual and corporate tax compliance experience and a 2015 Level III Candidate in the CFA Program.

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